Probability, Standard Deviation Band, Expected Range ORCL, AMZN

The Platinum Expected Range tool provides traders with outcome probabilities by using daily return data over a trader defined period of time. Last month's Platinum Toolbox article covered Expected Move calculations and Expected Range visuals available to assess a specific, short-term trade (Platinum Toolbox: Expected Moves for Trades, 4/3/09). This month's article provides two potential trades analyzed with Platinum's Standard Deviation [SD] Bands and other probability tools.

The trades provided are not recommendations; only you can determine if a specific trade suits your constraints and style while falling within acceptable risk parameters. The focus here is to show how Platinum probability tools can help you with your trade selections. Check out the Platinum Toolbox article from 4/2/09, "Expected Moves for Trades", for more detail on the terms used here.

Using Find Trades III, assume you have a bullish bias on price with relatively high implied volatility [IV]. Figure 1 provides the 21st (ORCL spread) and 23rd (AMZN spread) ranked results from a Put Vertical Spread (credit) search on Nasdaq-100 Index optionable stocks, sorting the trades by Odds. No other changes were made to the Find Trades III settings which were selected over the Find Trades II screen to allow the search engine to continue searching for trades.

The table below Figure 1 provides comparison data for the two spreads. In each case the bullish position is profitable to a varying degree above the breakeven.

 

Figure 1: Two Vertical Put Spreads with Risk & Odds
click here for larger view

Table 1: Vertical Put Spread Comparison - Jun Credit Spreads
click here for larger view

Although the risk to reward is better for the ORCL spread, a search by Odds has the AMZN spread closely ranked due to the improved probabilities for profits to be realized. Figures 2 and 3 provide a Risk Graph II view of the two spreads. Note the lighter blue line that appears at the breakeven price for each trade and where that line is relative to the red and blue standard deviation bands.

 

Figure 2: Risk Graph II for ORCL Jun Vertical Put Spread

The breakeven line in Figure 2 appears right at the lower blue SD Band (two SD) which was created using the 20-day statistical volatility [SV] for ORCL. This suggests there is a 95% chance price will be above the breakeven, assuming future price movement is similar to the past price movement for ORCL and the average price over the next 44 days is 19.06.

 

Figure 3: Risk Graph II for ORCL Jun Vertical Put Spread

The breakeven line in Figure 3 appears right below the lower blue SD Band (two SD) which was created using the 20-day statistical volatility [SV] for ORCL. According to the Probability of Profit [PoP] data, this suggests there is a 99% chance price will be above the breakeven, assuming future price movement is similar to the past price movement for AMZN and the average price over the next 44 days is 81.99.

In each case there is a high probability trade assuming the next 44 days are very similar to the last 20. You can broaden the look back time horizon to 90 days, which introduces more volatility here and makes the PoP values lower (but still relatively high). Using past movement for each stock is certainly a reasonable approach for trade assessment, but keep in mind there are still quite a few trading days for things to remain status quo.

As a result, the Expected Range for price viewed with SD Bands is extremely helpful for trade analysis, but has diminishing returns the further out to expiration. Assuming the 20-day SV increases in the next five days as price changes occur, the breakeven level may appear within the blue SD Bands. If the price and SV changes are significant enough, it can even move within the red SD Band making the probability of profit for the spread less than 68%.

Keeping the Odds in Your Favor

To use probabilities in your trading, you must understand basic information on how the data is obtained and how to interpret the results. The tools are best used to compare trades with the same number of days until expiration with reliability increasing as that time decreases. In addition to helping with trade selection, you can also use Expected Range and probability tools to manage existing positions.


Clare White
Contributing Writer and Options Strategist
Optionetics.com ~ Your Options Education Site

Questions for Clare? Please visit "Ask the Traders" on the Discussion board at the Optionetics.com homepage.